What Goes Up...

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From Sean Corrigan of Diapason Commodities Management

What Goes Up...?

In terms of markets, equities are sufficiently overpriced and arguably so widely over-owned as to be vulnerable to any disequilibrating change in mass perception.
Though the week which unfolded as this was being written was a more rocky one than has been the case of late, it had not – at publication time – led to an open and widespread retreat from Panglossianism.

Yes, it is true that, just as had happened six months ago when the Fed first started its public ruminations about whether and when to start to reduce its stimulus, emerging markets have suffered a further bout of turbulence and it is also true that some of these are facing increasingly fraught social and political tensions, to boot. The cynic would say that such periods of upheaval are almost intrinsic to their designation as "emerging" but he would also be quick to point out that such susceptibilities are supposed to be rewarded with either a yield premium or its converse, a price discount.

The ironists among market punters will even attempt to construe all this as a reason to buy more developed world stocks on the premise that the money flooding out of such places as Thailand, the Ukraine, Turkey, and Argentina will be parked in the S&P and the DAX (perhaps overlooking the fact that the purchase price of these now-unwanted positions was most likely borrowed, meaning that their liquidation will also extinguish the associated credit, not re-allocate it).

The Goldilocks lovers will also tend to assume that any such disruption will serve to delay the onset of genuine tightening and may even induce further ill-advised stimulus measures on the part of the major central banks. Certainly Madame Christine Defarge – that tax-sheltered tricoteuse who knits beside the guillotine set up for the hated bourgeoisie – has already begun to militate for such a response.

For their part, the biddable are already trying to drown out the noise of the Cacerolazo by making the fatuous argument that the EMs account for such a piffling portion of world GDP that their fate should be a matter of complete indifference to the rest of us. Needless to say this is a touch disingenuous at best. Their share of end consumption-biased GDP may be lower, but they account for an equivalent fraction, if not a small majority, of global industrial production – and they have been responsible for an even bigger proportion of its growth this past decade. Ditto for trade and ditto for resource use.

Thus, even if the party-goers are becoming a little bleary-eyed and the band a little ragged in its timing, the punch bowl has not yet been drained completely dry, while the only authority figures in sight have rather promised to recharge it than threatening to take it away. We have had sufficient say above about equities, per se.

For bonds we can only add that, for now, the 3% level in the 10-years suffices to satisfy even the most avid fixed income vigilante while a reversal in credit will probably require either an equity collapse or a macro-economic reversal to shake out the yield-hungry and risk purblind.

As for commodities, they sit at an interesting juncture, with total returns beginning to bump up against their long down trend, thanks partly to steep backwardations in energy and the collision between an unusually cold US winter and a deceleration in dry gas production in the nation’s vast shale deposits. Industrial metals having traded sideways for six months are now hemmed in against the last 4 ½ years’ lows and a trend drawn off 2011’s post-crash zenith (on a TR-in-Yuan basis). Precious metals, after their annus horribilis in 2013 find themselves in not wholly dissimilar circumstances. Thus for each, a break either way could prove decisive. Agri’s bad run now stretched back 15 months and 20% and, guess what, the index is resting on resistance drawn through a series of lows set over the past 3 ½ years, hard up against a (slightly less compelling) down trend from the 2012 local max.

Perhaps more compelling is that, on the longest of long-term charts stretching back a century, metals are back to the centre of the trend of 3.1% (real growth related?) annual stock outperformance, while crude is homing in rapidly on its own 1% trend slippage versus the S&P.

Now this is not to say that the market, having swung from commodity overvaluation in 1980, to a relative stock extreme at the end of the 90s, and then back in favour of commodities in 2011, cannot overshoot again to the equity side of the pendulum. But what it does mean is that any further outperformance will henceforth be adding a premium, not reducing a discount.

It is perhaps too pat to rehearse the argument that if economic activity picks up so as to justify major stock market forward pricing, commodities can only improve while if not, then the impact of such a disappointment on overbought, over-leveraged equities must be bigger than it will be on unloved, under-owned commodities. Life very rarely offers such clear win:win situations – or at least not without a good deal of profit - and morale sapping path dependence ahead of the twin goalposts.

But, for all that, it is not too much of a leap to say that if we believe that the scope for producing profits out of an accounting package rather than off the end of an assembly line is somewhere close to its achievable limits then the maintenance of high, much less higher, stock prices must surely require confirmation in the macro numbers, that finally, after two-and-a-half years of stagnation, we see a meaningful pick up in trade flows, accompanied by signs that smoke is once more emerging from Europe’s factory chimneys.

Additionally, given the close correspondence between emerging equities and industrial commodities, the cry of ‘Fire!’ in that particular Theatre of the Absurd will almost certainly do more damage to the mainstream asset than to the alternatives.

On such a frail foundation of relativities, if for no more solid a reason, it may accordingly be time to start to rebalance portfolios away from those formerly winning positions in which there are too many co-owners and back towards the recent losing ones which have few, if any, friends at all. Risk and reward, is supposed to be the mantra after all.